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Monday, December 8, 2008

Delta-Northwest: Will the merger work?

Thursday, 12 June 2008

Rising gas prices have heavily hurt multiple industries, but the airline industry could be the most dramatically damaged by rising fuel costs. Current economic conditions have made it nearly impossible for major airlines to earn a profit. To combat the gloomy economic forecast, Delta Airlines and Northwest Airlines announced that they had agreed to merge in a $3.1 billion deal. The proposed merger would create the world’s largest airline, surpassing industry leaders such as American and United.

Both Delta and Northwest hope that the merger will allow the two companies to reduce costs through consolidation. After Delta agreed to buy the Eagan, Minnesota based Northwest, the Delta president Ed Bastian said to Minnesota legislators that the US airline industry was reaching the “break point”. Since March 31, Aloha Airgroup Inc., ATA Airlines Inc., Frontier Airlines Holdings Inc., and Skybus Airlines Inc. have all filed for bankruptcy. With crude oil prices reaching over $100 a barrel, Delta and Northwest believed that the only way for the two companies to survive was to combine resources and consolidate. The new Delta-Northwest would also have over $7 billion in capital to withstand problems facing the industry and integrate the operations of the two companies.

Most industry analysts were not at all surprised by the proposed merger because of the possibility of huge savings. Currently, Delta and Northwest employ a combined 89,000 workers, while American, the current largest carrier, has 85,000 employees. Delta says that after restructuring the merged airline will employ 75,000 workers. However, the critical group in all airline labor negotiations, pilots, has refused to agree to any deal relating to combining the two pilot groups. Richard Anderson, current Delta CEO, decided to risk possible labor chaos and continue full speed with the merger. Anderson has already negotiated a new contract with Delta pilots that would give them a 3.5% raise but not to Northwest pilots. He hopes that this strategy will pressure Northwest pilots to quickly accept a deal. Northwest pilots have very few options to stop the merger other than appealing to legislatures or the Justice Department. However, the pilots can dramatically hinder the eventual outcome of the merger with labor slowdowns that could lead to delayed or canceled flights.

Even if Delta and Northwest manage to reach an agreement with the pilots, the combined company will unlikely lay off any pilots as the predicted cost cuts are all greatly hindered by the current structure of both airlines. In last year’s attempt by US Airways to take over Delta, US Airway predicted that by combining they could cut 10% of all flights and still meet demand. In the case of Delta and Northwest, many passengers on flights to Delta’s hub in Atlanta and Northwest’s hub in Memphis are only in transit to flights to other cities. By eliminating overlapping flights, Delta and Northwest could reduce costs by over $1 billion. However, Delta is unwilling to significantly shrink capacity or eliminate hubs, thus preventing significant cost savings. Delta only plans on scaling back capacity in Northwest’s Minneapolis hub and combining their airport operations and technology departments. Even these negligible savings could be offset by the costs of new labor deals and restructuring that the new company will have to face.

Instead of massively cutting costs, Delta and Northwest are instead trying to increase market share to increase revenues. The companies do have complimentary networks, with Delta securing a strong European presence, and Northwest controlling a wide Asia network. A combined Delta and Northwest would carry over 129 million passengers with 975 planes, both leading all other world carriers. Even with the most passengers, the new company would still trail Air France-KLM and Lufthansa in sales. Delta and Northwest would still be forced to raise prices to generate enough revenue to earn a profit.

To achieve greater market share, Delta and Northwest would have to attract customers away from the other large carriers. This proposition will get increasingly difficult with looming mergers that would create even larger competitors. The Delta-Northwest merger is just the beginning of a possible series of mergers that would further consolidate the airline industry. United Airlines and Continental Airlines have already entered into talks for a possible merger of the two companies. If this happens, they would create a company with an even greater market share than the combined Delta and Northwest.

Overall, the Delta and Northwest merger does not look like it will be the silver bullet for the two companies’ woes. Only by significantly reducing redundant flights can the two companies effectively save costs. To achieve lower operating costs, Delta-Northwest should consider shutting down redundant hubs. For example, Delta’s Atlanta hub covers the same geographic region as Northwest’s Memphis hub. By eliminating the smaller Memphis hub, Delta could still deliver the same services but only need to operate one hub instead of two. If the other major airlines also merge and refuse to cut costs, Delta-Northwest will just be the first of a new breed of bigger but still unprofitable airlines.